What Is a Covered Call Strategy?
The covered call strategy involves owning 100 shares of a stock and simultaneously selling one call option against those shares. You collect the option premium as income while retaining ownership of the stock. If the stock stays below the strike price at expiration, you keep both the premium and your shares. If the stock rises above the strike, your shares are called away at the strike price, and you profit from the stock appreciation plus the premium collected.
Covered calls are one of the most widely used options strategies in the world. They are approved for IRAs, considered conservative by the SEC, and used by pension funds, endowments, and individual investors alike. The CBOE BuyWrite Index (BXM) tracks a covered call strategy on the S&P 500 and has historically delivered comparable returns to the index with lower volatility.
Covered calls exploit the fact that options lose time value daily (theta decay). By selling calls against shares you own, you collect premium every month as time value erodes. Over 12 months, this premium income can add 12-36% in annualized return on top of any stock appreciation and dividends.
Covered Call Setup and Requirements
Setting Up a Covered Call
Covered Call Profit and Loss Formulas
Covered Call Strategy Example
- 1Premium income = $3.50 x 100 = $350
- 2Maximum profit = ($180-$170+$3.50) x 100 = $1,350
- 3Breakeven = $170 - $3.50 = $166.50
- 4Static return = $3.50/$170 = 2.06% (24.7% annualized)
- 5If AAPL stays below $180: Keep $350, sell another call next month
- 6If AAPL rises above $180: Shares called away, earn $1,350 total
Strike Price Selection Guide
| Strike Type | Premium | Assignment Probability | Static Return | Best For |
|---|---|---|---|---|
| Deep OTM (10%+ above) | Low ($0.50-1.50) | 5-15% | 0.3-0.9%/month | Maximum upside retention |
| Slightly OTM (3-5% above) | Moderate ($2-4) | 20-35% | 1.2-2.4%/month | Balanced income and upside |
| ATM (at current price) | High ($4-7) | ~50% | 2.5-4%/month | Maximum income |
| ITM (below current price) | Very High ($7+) | 65-85% | 4%+/month | Downside protection priority |
Managing Covered Call Positions
Active management significantly improves covered call returns. The most important management technique is buying back calls that have lost 50-80% of their value. This locks in most of the profit early and frees you to sell a new call at a higher strike or later expiration. Many traders follow the '50% rule': close the call when it has lost half its value, then sell a new one.
Rolling is another key management technique. If the stock rallies toward your strike price and you do not want to be assigned, you can roll the position by buying back the current call and selling a higher strike with a later expiration. The goal is to receive a net credit on the roll (collect more for the new call than you pay to close the old one).
Covered Call Outcomes
| Scenario | Stock Movement | What Happens | Result |
|---|---|---|---|
| Best case | Rises to just below strike | Call expires worthless, keep premium + unrealized gain | Premium income + stock appreciation |
| Good case | Stays flat | Call expires worthless, keep premium | Premium income reduces cost basis |
| Acceptable case | Rises above strike | Shares called away at strike | Premium + capital gain (capped) |
| Worst case | Drops significantly | Call expires worthless but stock losses | Premium cushions loss (limited protection) |
Avoid selling covered calls through earnings announcements unless you are willing to have shares called away at the strike price. Also be aware of ex-dividend dates: calls may be exercised early before the ex-date if the remaining time value is less than the dividend amount.